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Capacity utilization at a decade low
Thu, 24 Sep Pre-Open

Post financial crisis in 2008, corporates in the developed & developing nations went for massive capacity expansion. The reason for the same was low interest rates on borrowings. The interest rates in the developed countries were close to zero percent. However, in majority of cases the excess capacities have remained unutilized. Will this affect the capital expansion plans (capex) of the companies going forward?

Recently Indian Ratings (Ind-Ra) in a report stated, spending on capital expansion plans by manufacturing sector may take about two to three years. The report stated that the investments have slowed down in the past two years owing to subdued demand.

As per an article in Economic Times, earlier capex spending trends suggests that heavy capex spending usually starts when the capacity utilization nears the 90% level. However the current capacity utilization is hovering around a decade low. The report further goes on to say that with an 8% growth in demand volume, it may take around 24 to 36 months to revive the capex cycle. However if the demand does not pick up at the levels as assumed above, it would take as much as 36 to 42 months to revive the capex cycle!

The commodity prices are hovering at all-time lows. Commodity players contribute to a huge chunk of capex expense. It’s highly unlikely that commodity prices will revive in the near future. Therefore it is also unlikely that commodity players will take up large capex spending any time soon.

However, the current capex cycle may be revived by significant government spending. Usually the ‘Gross Fixed Capital Formation’ (GFCF) revives first. GFCF measures the value of acquisitions of new or existing fixed assets by the business sector and the government sector. The GFCF can be driven by significant government spending, followed by a pick-up in the private corporate spending. Currently the government spending is on the upward move, though the contribution from the private sector has not been encouraging.

Nevertheless, we believe any upturn in economic cycle and demand could be absorbed very well without any balance sheet strain as the corporates have already build up on capacities. The higher utilization levels in turn will lead to economies of scale and help companies fetch higher margins. In other words, most of the volume gains will flow directly to the bottomline and shareholder returns!

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